Collars are a mechanism by which investors may manage the risk inherent in owning an underlying asset such as a stock. A collar comprises two legs. The first is a long, out-of-the-money, put option, which is an option to sell the underlying asset at a set price. The put option leg protects against declining prices. The second leg is a short, out-of-the-money, call option which gives the right to purchase the underlying asset at a fixed price to another. The proceeds from the sale of the call option maybe used to finance the purchase of the put option, resulting in a zero-cost, or near-zero cost transaction.
In order to understand the risk managing characteristics of collars, a brief overview of options contracts and how they can be used to limit risk is helpful. Options contracts are well known financial instruments. An option is a contract that grants the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a certain date. There are basically two types of options: call options and put options. A call option confers the right to purchase the underlying asset at a specified price. A put option confers the right to sell the underlying asset at a specified price. In both cases the specified price is known as the “strike price.”
Options are contracts between investors. A first investor must purchase an option from second investor. The first investor having purchased the option from the second investor is said to have taken a long position relative to the option and the second investor is said to have taken a short position. The amount paid by the long investor to the short investor is known as the option price. Whether or not the option is exercised (i.e. the option is invoked to either purchase or sell the underlying asset) is solely in the discretion of the long investor holding the option. A call option becomes valuable, is “in-the-money,” if the market price of the underlying asset rises above the strike price. Otherwise, the option is “out-of-the-money” and has no value. When a long investor elects to exercise an in-the-money call option, the long investor pays the strike price to the short investor and the short investor delivers the underlying asset to the long investor. Conversely a put option becomes valuable, is “in-the-money” when the market price of the underlying asset falls below the strike price of the option. Otherwise, the option is “out-of-the-money” and has no value. When a long investor elects to exercise an in-the-money put option, the short investor must pay the strike price to the long investor and the long investor delivers the underlying asset to the short investor.
In many cases the parties may choose to forego delivery of the underlying asset and settle the contract in cash. Cash settlement merely requires the short investor to pay the long investor the difference between the strike price and the prevailing market price of the underlying asset. If the option expires out-of-the-money, the market price of the underlying remains below the strike price of a call option or above the strike price of a put option, the short investor pays nothing to the long investor and retains the option price.
Options can be highly speculative investments. They can also be used as tools for managing risk. Zero-cost or near-zero-cost collars are a low cost mechanism that can be used to limit the risk that an asset will lose a significant amount of its value. In order to understand the risk management potential of options collars it is helpful to review the risk-reward curves for various investments. FIG. 1 is a graph 100 showing the risk-reward curve 102 for an investor who has invested directly in an asset. The asset may be, for example, a share of stock in a hypothetical company XYZ Corp. The horizontal axis of the graph represents the market price of the asset, and the vertical axis represents the investor's profits or losses from his or her investment. In this example, the investor purchased the asset at a market value of $50. The investor's profits or losses are tied directly to the market price of the asset. If the market price rises above $50 the investor sees a profit. If the market price falls below $50 the investor sustains a loss. Profits or losses are linear, based solely on the market price of the asset. From curve 102 it can be seen that the investor's maximum risk is $50, the total amount of his or her investment. The potential gain, however, is substantially unlimited.
FIG. 2 is a graph 110 showing the risk-reward curve 112 for an investor who has taken a long position in a call option. The horizontal axis represents the market price of the underlying asset, e.g. a share of XYZ Corp. The example shown has a strike price of $50 and an option price of $10. If the market price of the underlying asset remains below the $50 strike price, the option remains worthless and the long investor risks losing the $10 cost of the option. This condition is represented by the horizontal portion 114 of the risk-reward curve 112. If the market price of the underlying rises above the strike price however, the option is in-the-money and has value. This situation is represented by the positive slope portion 116 of the risk-reward curve. The value of the in-the-money option is equal to the difference between the market value of the underlying asset and the strike price. When this difference exceeds the option price, $10, the long investor begins to see a profit. As is visually quite clear from the graph, the long investor's risk is limited to the option price, but the potential gain is essentially unbounded.
FIG. 3 is a graph 120 showing the risk-reward curve 122 for an investor who has taken the opposite position from the investor of FIG. 2, namely a short position in a call option for XYZ Corp. The risk-reward curve 122 is the inverse of curve 112 shown in FIG. 2. The risk-reward curve 122 also comprises two distinct legs. The first leg 124 corresponds to the option being out-of-the-money, the market price of the underlying asset remaining below the strike price. Under these market conditions the option is worthless and the short investor retains the $10 option price paid by the long investor. Once the market price of the underlying asset moves above the strike price, however, the option acquires value and the short investor is obligated to pay the long investor an amount equal to the difference between the market price of the underlying asset and the strike price. If this amount exceeds the $10 options price the short investor suffers a loss. The negative slope portion 126 of the risk-reward curve corresponds to the call option being-in-the-money. As the second leg 126 of the risk-reward curve 122 shows, the potential loss to the short investor is substantially unlimited, whereas the potential gain is limited to the received option price.
Next we turn to FIG. 4 which is a graph 130 showing a risk-reward-curve 132 for an investor who has taken a long position in a put option. In this case the option again has a strike price of $50 and a $10 option price. Since a put option represents the right to sell the underlying asset at the strike price, a put option is in-the-money when the market price of the underlying asset drops below the strike price. As with the risk-reward curves in FIGS. 2 and 3, curve 132 comprises two distinct legs. The first negatively sloped leg 134 corresponds to the option being in-the-money, the market price of the underlying asset below the strike price of the put option. The second horizontal leg 136 corresponds to the option being out-of-the-money, the value of the underlying asset above the strike price of the put option. The maximum return on a put option is the strike price minus the option price. This assumes that the underlying asset has completely lost its value and become worthless. As long as the difference between the strike price and the value of the underlying asset exceeds the option price, in this case $10, the long investor who purchased the put option realizes a profit. If the value of the underlying asset remains above the strike price, the put option is worthless and the long investor experiences a loss equal to the price of the option.
Finally, FIG. 5 shows a graph 140 of a risk-reward curve 142 for an investor who takes a short position in a put option. Again, the risk-reward curve comprises two distinct legs. The first leg 144 occurs when the put option is in-the-money, the market price of the underlying asset has moved below the strike price. The second leg 146 corresponds to the option being out-of-the-money. When the option is out-of-the-money the option is worthless and the short investor retains the option price, realizing a small profit. When the put option is in-the-money, however, the short investor is obligated to purchase the underlying asset at the strike regardless of the prevailing market price. If the difference between the strike price and the prevailing market price of the underlying asset is greater than the option price paid for the option, the short investor experiences a loss. The maximum loss the short investor can sustain if the underlying asset loses all of its value and becomes worthless is equal to the strike price minus the option price.
Options may be employed to manage the risk of changes in the value of an underlying asset. For example, referring back to FIG. 1, where an investor purchases a share of XYZ Corp. for $50. Holding this single share, the investor's maximum risk exposure is $50. If the company goes out of business and the stock becomes worthless the investor loses his entire $50 investment. If, however, the investor purchases a put option with a strike price of, for example $40, the investor locks in the right to sell the stock at $40 regardless of any further price declines. The investor's maximum loss would be the cost of the put option $10 plus the difference between the purchase price of the asset ($50) and the strike price of the put option ($40). In this case a total of $20. The investor's maximum loss can be further limited by financing the $10 purchase of a put option by a corresponding sale of a call option. If the investor sells a call option for the same price as the put option described above, he has limited his downside risk at essentially “zero cost.” The transaction is zero-cost in the sense that the downside risk protection did not require a cash outlay. In reality, however, the downside risk protection was purchased at the expense of up-side potential. By selling a call option the investor is obligated to sell the underlying asset (his share of XYZ Corp.) at the strike price of the call option regardless of how high the price of the stock rises. Thus, the investor's upside potential is limited to the strike price of the call option.
The arrangement just described is known as a zero cost collar. It is zero cost since the sale of the call option is used to offset the cost of purchasing the put option. The arrangement places a “collar” on the value of the investor's investment, placing a finite limit on both downside losses and upside gains. FIG. 6 shows a graph 150 of a risk-reward-curve 152 of a zero costs collar as described. The risk-reward curve 152 is essentially the sum of the risk-reward curve 152 for the underlying asset (FIG. 1), the risk-reward curve 122 for short call option (FIG. 3) and the risk-reward curve 130 for the long put option (FIG. 4). The risk-reward curve 152 comprises 3 segments. The first 154 represents the investor's maximum loss if the price of the underlying asset falls below the strike price of the long put option. The third segment 158 represents the investor's maximum gain if the price of the underlying asset rises above the strike price of the short call option. The narrow band 156 in the middle represents the investor's risk exposure to price fluctuations between the strike price of the put option and the strike price of the call option. With the zero cost collar the investors' maximum losses and maximum gains are limited to this narrow range 156.
Collars have been traded in the over-the-counter market. Investors may assemble the various pieces using customized contracts to create various offsetting collar positions. Heretofore, collars have not been traded on exchanges. Trading such a product on an exchange is complicated by the fact that exchanges are limited to trading standard option contracts having prescribed strike-price intervals. Using standard option contracts it is difficult to assemble a package of off-setting positions. This complication is absent in the over-the-counter market since dealers are free to customize contracts as necessary. Such customization, however, may limit the liquidity of the over the counter packaged collar options.